What Is a Stock Market Bubble?
Investors live in constant fear of a stock market bubble. Major economic losses tend to occur when a bubble bursts, usually sending everyone looking for financial havens to park their money and wait for the worst.
To avoid the worst of these accidents, you need to understand what causes a bubble and how it bursts.
What is a bubble?
A bubble occurs when the price of something begins to rise rapidly and exceed its true value. In the case of stocks, this is usually when the price is well above the fundamentals (financials) of the company. This behavior usually cannot be sustained, after all, market forces always push prices towards a balance between how much people are willing to pay for its actions and how profitable it is.
Prices that suddenly fall and cause economic losses are usually called a burst bubble.
The first record of an economic bubble that we have dates back to 1637, when Tulip Mania caused the prices of Dutch tulips to hyperinflation. Trading established many firsts in international trade – including the concept of futures contracts. It goes without saying that this market eventually collapsed and left thousands of people bankrupt.
A more recent example would have been the housing bubble in the United States in 2006, which led to the subprime mortgage crisis that occurred between 2007 and 2010. Here, banks and financial institutions began to provide home loans. to pretty much anyone who wanted one. This led to a rapid rise in house prices as demand soared.
In 2007, it was found that many borrowers could not afford their new mortgage and were in default. This brought down real estate prices due to a sudden increase in the supply of goods; as a result, many mortgage-backed securities have become worthless.
Can we predict it?
One would expect our modern calculations and models to be able to predict bubbles before they occur, which would allow regulators to introduce guidelines to correct the market before it bursts.
But this is not the case. It is almost impossible to tell if the price of an asset is within its intrinsic value. After all, who are the economists to say that a house is too expensive if there are still people willing to pay that price?
For this reason, all bubbles are only identified retrospectively – that is, after they have already occurred.
After all, not all price cuts count as a blast. It could simply be the market correcting itself and bringing prices back to a level that correctly reflects the value of the asset.
That said, economist William Quinn points out that there are common themes in all bubbles: 1) there is an abundance of money, 2) they occur in assets that have recently become easy to buy, and 3) they involve speculation on future price increases.
These themes don’t guarantee that a bubble will form, but they do give you some pointers on what to look for if you’re worried.
Is there a bubble on the stock market?
Locally, the volume of trade on Bursa Malaysia jumped 125% year on year. According to Bursa Malaysia, the number of new Central Depository System (CDS) accounts opened from January to July of this year was 218,000, up from 97,000 in 2019.
With the six-month moratorium on loan repayments ending this month, the million ringgit question is whether all the money in Bursa will suddenly dry up.
While there is certainly the risk that investors will suddenly withdraw their funds to deal with loan repayments, there does not appear to be a bubble just yet. Bursa himself points out that telltale signs of a bubble are not present. The influx of new accounts does not equate to an abundance of funds, while there have been few speculative purchases in select markets.
Having said that, we don’t know what will happen when the moratorium ends.
What can you do about it?
If you’re worried about a bubble bursting, you have two options: come in and try to climb the bubble to the top, or just sit there and go looking for bargains afterwards.
Riding the bubble and cashing at the top isn’t something we recommend unless you are well connected and have a lot of experience. It is not for the faint of heart as bubbles can burst at any time. It is basically about timing the market and carries the greatest risk for any investor.
Alternatively, you can park your investments and wait for the crash to end. Once all the losses are made, you can go shopping for undervalued stocks. You will still have to be careful when selecting from the trash, as some actions may not recover.
Whatever you do, it’s important to avoid panic. Bubbles are bursting and stock markets are crashing all the time. These markets are also recovering all the time. So avoid doing anything in a hurry and do your homework before making any changes to your investment strategy.
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